The latest from James Montier of GMO is a must read as always. He discusses the rise of tail risk protection and the ways in which investors can protect themselves. He provides three specific forms of protection:
“We are aware of three general groups of tail risk protection from which investors may choose.
1. Cash – This is perhaps the oldest, easiest, and most underrated source of tail risk protection. If one is worried about systemic illiquidity events or drawdown risks, then what better way to help than keeping some dry powder in the form of cash – the most liquid of all assets. (There is much more on the joy of cash to come shortly.)
2. Options/contingent claims – Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases. A prime example was the credit default swaps that were a result of the demand for collateralized debt obligations. These instruments were priced on the assumption that there would be no nation-wide decline in house prices, and thus offered a great opportunity (even without the benefit of hindsight) for those who were concerned that such an outcome was more plausible than the market thought. Here, one caveat stands out above all others: one must be cautious of the dangers of over-engineering in this area of tail risk protection. It is too easy to construct an option that pays out under a very specific set of circumstances, and to do so relatively cheaply. But, of course, such an instrument tautologically only pays off under the realization of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk protection.
3. Strategies that are negatively correlated with tail risk – For the specific type of tail risk (illiquidity events) under consideration here, long volatility strategies are often said to be negatively correlated. The simplest example of such a strategy is just to buy volatility contracts (bearing in mind the roll return will be negative given the upward-sloping term structure of volatility). In the recent crisis, a dollar neutral long quality/short junk portfolio acted very much like a long volatility strategy (with the added benefit of an expected positive return, in contrast to most insurance options).”